Foreign Land Mines Make U.S. Bonds Look Good

The U.S. government's record debt issuance may give rise to investor anxiety down the road, but with Greece and other nations' credit ratings in play, U.S. Treasurys are holding on to their appeal.

Credit problems are mounting in Greece and a handful of other euro zone countries, derisively called "PIIGS" in trading circles, driving investors away from their sovereign debt.

"I think there is nowhere else to put your money," Tom di Galoma, head of rates trading with Guggenheim Partners in New York, said of the resilient safety bid for U.S. Treasurys.

The acronym "PIIGS" refers to Portugal, Italy, Ireland, Greece and Spain. Greece, seen as one of the weakest euro zone members, was slapped with rating downgrades in recent days due to its worsening fiscal situation.

Spain risks a debt rating downgrade in two years if its government does not take tough action on its fiscal deficit, Standard & Poor's warned on Wednesday.

Sovereign risks have even spread beyond Europe with debt-laden Dubai scrambling to avoid a default.

Treasurys look pristine in comparison. The $7.4 trillion Treasurys market is still considered the most liquid debt market in the world.

But the favorable contrast between U.S. and other countries' debt may not last. The United States is clinging to its AAA credit rating, the gold standard in the debt market, even as rating agencies have warned that if the world's biggest debtor nation fails to put its fiscal house in order in the next three to five years, it could face downgrades.

Primary dealers, firms that do business directly with the U.S. Federal Reserve, say they are even seeing some wariness among clients over the debt from the world's top economies.

"We're getting some questions about the G3 countries but I think the concern is overblown," said Michael Cloherty, head of U.S. rates research at BofA Merrill Lynch Global Research in New York. "The sovereign risk in these countries will play out over the next 20 years, so it's going to be about governments making tough decisions."

The U.S. Treasury has ramped up its debt sales to raise money to make up for falling tax receipts and to fund its economic stimulus and financial bailouts. It is expected to sell $1.4 trillion in new debt in the current fiscal year after issuing $1.7 trillion last fiscal year.

"Investors right now are a bit conflicted between certain emerging markets to prospects for Treasury supply and Treasury yield heading into next year," said Colin Lundgren, head of institutional fixed-income at RiverSource Investments in Minneapolis.

Emerging market economies have rebounded quickly from the financial crisis and while their interest rates have been cut as their economic fundamentals have improved, they still offer a hefty premium to U.S. government debt.

The U.S. will have a number of years to get its budget in order while holding on to the highest possible credit rating.

"The size of the U.S. is what is keeping its AAA solid for now," said Rajiv Setia, director of fixed income strategy at Barclays Capital in New York.

But Setia pointed to several possible triggers for a downgrade, such as a disorderly decline in the dollar's value or a sharp spike in interest rates.

Until very recently, weakness in the U.S. dollar was compounding the long-term concern for Treasurys. While the greenback has recouped some ground on the euro in December, the euro zone currency is still up 2.3 percent against the greenback this year.

The continued erosion of the greenback has worried foreign governments. China, OPEC and other U.S. trading partners have been heavy buyers of U.S. government debt in an effort to recycle the dollar reserves they have accumulated.

China, the biggest holder of Treasurys, has signaled its intention to diversify its $2 trillion currency reserves away from the dollar, albeit gradually. China owned $799 billion of U.S. government debt in October, according to data this week.

In general, U.S. debt is tied closely with the dollar reserve ratios held by foreign central banks. Countries outside the U.S. currently hold around 62 percent of their reserves in dollars; if that ratio dropped to 55 percent, U.S. debt could lose its AAA status, Setia added.

But even without a top rating for its debt, the U.S. is still likely to look more attractive than other countries.